Don’t Ditch Those Bonds

Time to rethink conventional investment wisdom?

CDs and very short-term bond funds are fine for cash you need soon, but for down the road you should stay with intermediate-term funds. — Peter Gridley

En español | Classic advice bout diversifying investments tells us that we should choose stocks for growth, high-quality bonds for income and banks for cash. So those of us in — ahem — the prime of life usually own some bonds or bond mutual funds.

An ironclad law of the universe says that when interest rates rise, the market value of bonds goes down. Rates popped this spring and bond funds took quick hits — losses of 0.5 to 1 percent or so for short-term bonds, 2 to 4 percent for intermediate terms, and 7 percent or more for longer terms. (Another ironclad law says that longer-term funds swing more sharply with interest rate changes than short-term bonds do.) With interest rates predicted to climb, bond fund holders are wondering if they should cut and run.

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Surprising benefits

I say no, and for a reason that you might not expect: It's actually possible for your bond funds to benefit from rising interest rates, if you're reinvesting dividends, making only modest withdrawals and planning to hold on to the funds for 20 years or more. That's because your fund is buying the higher-rate securities that are available on the market now, which raises your income yield. Over the years, your gains can more than make up for the principal you lost.

For an example of how this works, I turned to actuary and financial planner Joe Tomlinson of Greenville, Maine. He looked at funds invested in Treasury inflation-protected securities (TIPS), whose drop in value especially alarmed conservative investors. The internal value of TIPS is increased twice a year by the inflation rate, so many investors felt safe.

Say that you invested $290,000 last April 1 in Vanguard's TIPS fund to help pay for your retirement over 25 years. You planned on withdrawing $10,000 in the first year, with an increase to cover inflation each year after that. By the end of June, rising rates had pushed up your fund's yield by 0.83 percentage points. Its market value fell 7.4 percent and you took a $21,500 loss.

Plans ruined? Not at all, Tomlinson says. Thanks to the higher yield, you could increase your withdrawal to $10,350 and the money would still be expected to last for 25 years.

Two things have made TIPS more volatile than other funds. First, they contain more longer-term securities. Second, consumer price increases have been running at historic lows. When interest rates rise and inflation doesn't, TIPS tend to underperform.